Bank Failures Give Lessons in Missed Basics

Allen North

The summertime collapse of IndyMac represented the second-largest U.S. bank failure ever. IndyMac, a $32 billion federal savings bank, based in Pasadena, Calif., was the fifth-largest mortgage lender in the country. Locally, Arkansas experienced its first bank failure in seven years when the Comptroller of the Currency closed ANB Financial of Bentonville on May 9.

Both failures were widely publicized due to the banks' size and overall business strategies. According to published reports, IndyMac suffered a liquidity crisis caused by a deposit run. IndyMac was a large originator of alt-A mortgages, which were often made to borrowers with poor credit. As the secondary market for these loans collapsed, the bank's liquidity became strained.

News reports asserted that ANB lacked the capital to withstand a high level of non-performing loans. ANB had approximately $1.9 billion in total assets, roughly 90 percent funded with brokered deposits, which are more volatile than core deposits. According to published reports, ANB's past due and non-accrual loans more than tripled during the six months preceding closure.

The FDIC estimates that the failure of IndyMac will result in a material loss to the deposit insurance fund of approximately $8 billion, while ANB's failure will amount to a $214 million loss to the fund.

In light of these failures, let's look at issues that affect a bank's financial condition and what lessons can be learned. The problems typically fall into one or more of the following categories:

  • Management forgets/ignores the principle of risk and return.
  • Management fails to properly diversify.
  • Bank personnel engage in activities that they do not fully understand.
  • Management is incompetent, or a fraud is committed.

Banks can often achieve impressive returns-which far exceed peer levels-by employing aggressive growth strategies, such as expanding into unfamiliar markets, lowering overall credit quality or exposing the bank to high-risk commercial real estate concentrations. Often, funding strategies involve more costly and less stable wholesale funding in the form of brokered deposits. The volatile combination of aggressive asset growth funded with wholesale sources can create tremendous strains on liquidity and increase the bank's sensitivity to interest rate fluctuations.

A better means of achieving growth is a measured approach with an appropriate funding and risk management strategy established prior to any significant growth.

Boards of directors should give close attention to the time-proven fundamentals of lending during good economic times. Otherwise, issues will inevitably arise when credit conditions deteriorate.

Additionally, boards should pay close attention to the liability side of the bank's balance sheets. Brokered deposits, used within prudent levels, can serve as a legitimate source of funding. However, if asset quality deteriorates and capital ratios fall, prompt corrective action triggers can restrict the renewal of brokered deposits. (For more, see "Prompt Corrective Action: What Does It Mean for a Bank's Liquidity?" in this issue's online-only content.)

Boards of all banks should also consider contingent funding plans. Where appropriate, these plans should include completing the required documents and pledging collateral for contingency access to the discount window. (See for more.)


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